Here are a couple of recent questions. Odds are good you’ve thought of the same ones…

Hi Stacy,
Would you please clarify the benefits of having a Health Care FSA and Dependent Care FSA versus deducting your healthcare expenses during your taxes? Which is a better option (saves me more?) In addition, in order to deduct healthcare expenses do they need to add up to at least 7% of your income? And if so, is it gross income or adjusted gross?
Please help.
– Karla

Here’s your answer, Karla!

FSA stands for Flexible Spending Account. We’ve written about them before – see How to Flex Your Financial Muscle With FSAs. The idea behind them is simple: You have your employer take money out of your paycheck and set it aside for qualified medical or dependent care expenses. The money you’ve set aside isn’t taxed: no federal tax, no employment taxes. Nor is it taxed when you spend it, providing it’s for allowable stuff.

Qualified medical expenses are explained in Publication 502, Medical and Dental Expenses (PDF), but according to the IRS, “allowable medical expenses are the costs of diagnosis, cure, mitigation, treatment, or prevention of disease, and the costs for treatments affecting any part or function of the body. These expenses include payments for legal medical services rendered by physicians, surgeons, dentists, and other medical practitioners. They include the costs of equipment, supplies, and diagnostic devices needed for these purposes.”

Dependent care expenses can be used for child care payments or for the care of dependents of any age who are physically or mentally incapable of self-care, as well as adult day care for senior citizens. But you have to be able to claim the people receiving the care as dependents on your taxes. The dependent care FSA is federally capped at $5,000 per year, per household. Both spouses should also be working – the purpose of the tax break is to help two-income households.

What’s the catch?

By using an FSA, any money you spend on medical expenses is tax-free. Sounds like a screaming deal, right? It would be, but as with many gifts offered by Uncle Sam, this one comes with strings attached. First, your employer must offer an FSA plan – although many big employers do, they’re not required to. Then there’s the biggest catch: Money you put in your FSA must be spent by the end of the calendar year. In other words, use it or lose it.

While child-care expenses are fairly predictable, medical expenses are a different story. There are some you can anticipate, like annual eye exams, physical therapy, or prescriptions, but you can’t foresee many of the medical expenses you might incur. That’s a bummer, because you can’t put money away that you don’t know you’ll need and the last thing you want to do is leave money in your plan unused.

Prior to 2011, you could use money in your FSA to buy over-the-counter drugs like aspirin or cold remedies. But the ability to do that is gone. As the IRS puts it: “Effective Jan. 1, 2011, distributions from health FSAs will be allowed to reimburse the cost of over-the-counter medicines or drugs only if they are purchased with a prescription.” (What is it about the government that makes them talk in circles?)

There are several calculators online that purport to help you decide how much to contribute to an FSA. Here’s one example.

Deducting your medical expenses

Another way to get tax relief with medical expenses is simply to deduct them as an itemized deduction on your tax return. To do so, however, you’ll have to be really sick, really low-income, or both. That’s becasue medical expenses are only deductible to the extent they exceed 7.5 percent of your adjusted gross income. For example, if your adjusted gross income is $100,000, you’ll have to spend more than $7,500 on qualified medical expenses before you deduct a dime. So if you have $8,000 of medical expenses, your deduction will amount to $500. Whoopee.

By the way, for the 99.99 percent of you who have no idea what “adjusted gross income” means, the simplest thing to do is pull out last year’s tax return and look for it. But adjusted gross income is basically all the money you take in, minus some, well, adjustments. There’s a bunch – you can check them out on this Wikipedia page – but here are the most common:

Money you put in a health savings account

Qualified moving expenses

One-half of self-employment tax

Contributions to qualified retirement accounts, like IRAs

Alimony paid (If you receive alimony, that counts in your income)

With limitations and exceptions, some college tuition, fees, and student loan interest

Now to answer Karla’s question…

Now that I’ve droned on explaining how FSAs and the medical expense deduction work, we should all know the answer to Karla’s question of which is better. FSAs are. Why? Because every dime you set aside and spend in your FSA is essentially a deduction: It reduces the income you’re taxed on. When you deduct your medical expenses, only the amount that exceeds 7.5 percent of your adjusted gross income does you any good.

The only fly in the ointment is that in order to use an FSA effectively, you have to accurately forecast what your expenses will be and not leave money in your account at the end of the year.

Got a question of your own?

Send it to me and I’ll try to answer it, on two conditions: First, it must apply to a lot of people and not only to your personal situation. Second, you won’t hate me if I don’t get to it. I get too many questions to answer them all.

It's not the usual blah, blah, blah

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